Risk Management & Valuation

Tutorial Session 4
Zhengming Li
[email protected]

Feb 4, 2022
Marking: Breakdown and Criteria
BREAKDOWN WEIGHTING

Question 1 20%

Question 2 30%

Question 3 30%

Question 4 20%

Bonus (overall formatting) 5%

KNOWLEDGE Knowledge of the relevant subject matter for the question

UNDERSTANDING Demonstrated understanding of the relevant subject matter

ANALYSIS Depth of analysis of the question

CLARITY Presenting the answer in an organized manner

Introduction
► These slides review the Diageo assignment

► There are no unique correct answers to these questions

► The slides just give suggestions for a good way to proceed

► Always important to be clear about assumptions and justify the approach taken

► Feedback expected by 22/02/2022

Q1: Diageo’s Business Description
► Food and beverage alcohol company
- Formed in November 1997 from the merger of Grand Metropolitan plc and Guinness plc
- Motivation of merger: cost savings due to marketing synergies, reduction in overhead expenses,
and production and purchasing efficiencies
- Very international: sales in more than 140 countries

► Main business divisions

- Spirits and wine business (largest and fastest growing segment): produced and marketed beverage
alcohol
- Guinness brewing: produced and sold beer (in the process of being integrated)
- Package foods: Pillsbury (leading producer of packaged food products)
- Fast foods: Burger King (global fast-food restaurant)

► New strategy: focusing on beverage alcohol business

- Sell Pillsbury to General Mills and Burger King through initial public offering (IPO)
- Continued growth could come from organic growth or from potential acquisitions
- Generally, Diageo is in a strong position to expand its beverage spirits business
Q1: Diageo’s Operation Performance

FY98 FY99 FY00

Sales growth -7.36% -1.95% 0.64%
Net income growth 30.42% 7.17% 3.61%
Net profit margin 7.31% 7.99% 8.22%
Asset turnover 0.70 0.72 0.74
Equity multiplier 3.34 3.54 3.05
Return on assets 5.09% 5.79% 6.05%
Return on equity 17.02% 20.51% 18.47%

► Key performance indicators:

- Sales growth: increasing, net income growth: decreasing
- Net profit margin: increasing, asset turnover: increasing, equity multiplier: increasing
then decreasing
- Return on assets: increasing, return on equity: increasing then decreasing
Q2: Valuation of Diageo I: Comparable Companies

Class of business EBIT (FY00) Comparable company EV

EV/EBIT
Spirits and wine 1,002 11.0x 11,022

Beer 284 16.4x 4,658

Packaged food 492 13.5x 6,642

Restaurants 202 19.2x 3,878

Diageo total 1,980 26,200

► Market value of equity = Enterprise value – (Book value of short- and long-term debt – Cash)
- Market value of equity (using comparables method) = 26,200 – (3,066 + 3,816 – 1,063) = 20,381
- Close to the observed market value of equity (20,144) from financial statements
Q2: Valuation of Diageo II: DCF approach

FY00 Assumption/source

EBIT 2,043 Operating profit from financial statements

EBIT*(1 - t) 1,430 Effective tax rate = 30%

Depreciation 986 Depreciation = 10% of fixed assets

CAPEX 488 Net capital expenditures from financial statements

Change in NWC -28 NWC = Cash + Accounts receivable+ Inventories –

Accounts payable

Free Cash Flow 1,956 FCF = EBIT*(1-t) + Depreciation – CAPEX - ΔNWC

► Growing perpetuity formula (assume WACC = 8% and future FCF growth rate = 2.5%)

𝐹𝐶𝐹!""# 𝐹𝐶𝐹!""" 1 + 𝑔 1,956× 1 + 2.5%

𝐸𝑉!""" = = = = 36,460
𝑟$%&& − 𝑔 𝑟$%&& − 𝑔 8% − 2.5%

► Market value of equity = Enterprise value – (Book value of short- and long-term debt – Cash)

- Market value of equity (using DCF method) = 36,460 – (3,066 + 3,816 – 1,063) = 30,641
Q3: Financial Policy and Capital Structure
► Conservative financial policy
- The enlarged group’s policy will be to manage actively the capital structure so as to keep the interest cover
ratio, in normal circumstances, within a band of five to eight times.
- Maintain the credit rating of A+ by maintaining interest coverage of 5 to 8 times
- As a secondary target, Diageo sought to keep EBITDA/Total debt at about 30% to 35%
- The strong debt rating provided substantial benefits for Diageo in the capital markets

► Interest coverage ratio = EBIT/Interest expense (or EBITDA/Interest expense)

- From 1998 to 2000: 7.23, 4.55, 5.04

► EBITDA/Total debt = (EBIT + Depreciation)/Total debt

- Assume that depreciation = 10% of fixed assets
- From 1998 to 2000: 22.86%, 25.14%, 27.92%

► Capital structure: Debt-to-equity ratio = Total debt/Total equity

- From 1998 to 2000: 2.34, 2.54, 2.05

- Explain the current capital structure
Q3: Financial Policy Share repurchase: £ 2,662m Share repurchase: £ 80m
Dividends: £ 695m Dividends: £ 710m
Retention ratio: -2.82 Retention ratio: 0.19
New debt: £ 2,097m Debt repayment: £ 544m
1997 1999

1998 2000
Share repurchase: £ 1,336m
Dividends: £ 702m
Retention ratio: -1.16
► Share repurchase and dividend policies Debt repayment: £ 716m

- Large share repurchases in 1998 and 1999, consistent payout policy

- Retention ratio: measures the proportion of net income that are not paid out to investors as
dividends or stock buybacks

Share repurchase + Dividends

Retention ratio = 1 −
Net income

► Debt financing: issued new debt in 1998, repaid some debt in 1999 and 2000

- Leveraged buyback: the company takes on additional debt to repurchase stocks

- Dividend recapitalization: the company takes on new debt in order to pay dividends
Q3: Main Sources and Uses of Funds
► Main sources of funds
- Operating profits
- Divestitures
- Cash from investments
- New debt

► Main uses of funds

- Share repurchases
- Dividends
- Taxes paid
- Capital expenditures
Q3: Sustainable Growth Rate
► Sustainable growth rate (SGR)

SGR = ROE × Retention ratio

- We use Dividends paid in cash flows statement; you can also use Dividend in income statement
- With share repurchases (from 1998 to 2000): -47.99%, -23.86%, 3.52%
- Without share repurchases (from 1998 to 2000): 3.56%, 5.23%, 5.03%

► Comparing SGR to asset growth rate

FY98 FY99 FY00

SGR-1 (Share repurchases and dividends) -47.99% -23.86% 3.52%

SGR-2 (Dividends only) 3.56% 5.23% 5.03%

Asset growth rate -0.77% -5.66% -0.87%

- 1998 and 1999: SGR-1 < Asset growth rate, SGR-2 > Asset growth rate
- 2000: SGR-1, SGR-2 > Asset growth rate
Q4: Should Diageo Increase Leverage?
► Advantages:
- Tax shield: interest expense is tax deductible, so leverage reduces tax bill and increases firm value
- Boosting return on equity (ROE): recall Dupont identity
- Managerial discipline: threat of financial distress and being fired may commit managers more fully
to improve firm performance

► Disadvantages:
- Probability of distress: higher leverage increases the financial risk of the company (the probability
of distress)
- Loss of financial flexibility: debt overhang problem, difficult to raise new funding when in (or close
to) distress, might have to forego positive NPV projects
- Inefficient liquidation: company in distress might sell assets quickly to avoid bankruptcy (fire
sales)
- External environment: competitors might compete more aggressively to drive Diageo out of
business; suppliers might tighten trade credit if they are concerned that they will not get paid